Derivative Standing When Debtors Are Limited Partnerships and Limited Liability Companies

It is well settled that creditors of an insolvent corporation can obtain derivative standing to pursue claims for breach of fiduciary duty against officers and directors.  The same principle, however, does not always apply for creditors of limited liability companies (LLCs) and limited partnerships (LPs).  The Delaware Bankruptcy Court in Gavin/Solmonese LLC v. Citadel Energy Partners LLC (In re Citadel Watford City Disposal Partners), 2019 Bankr. LEXIS 1375 (Bankr. D. Del. May 2, 2019 (Carey, J.), recently held that a liquidation trustee did not have derivative standing to pursue a breach of fiduciary duty claim on behalf of creditors when the debtors were LLC’s and an LP.

Development of Derivative Standing Law in Delaware

In 2010, the Delaware Court of Chancery held that creditors of an insolvent LLC do not have standing under Delaware law to sue derivatively for breach of fiduciary duty claims.  CMLV, LLC v. Bax, 6 A.3d 238 (Del Ch. 2010).  In reaching its decision, the Chancery Court examined section 18-1002 of the Delaware Limited Liability Company Act (the “LLC Act”), entitled “Proper Plaintiff,” that provides: “In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of the bring the action and . . [a]t the time of the transaction of which the plaintiff complains.”   6 Del. C. § 18-1002.  The Court interpreted the LLC Act as limiting standing to pursue derivative claims only to members or assignees of liability company interests in the LLC and not creditors.  See Bax, 6 A.3d 238.

In 2018, in HH Liquidation, LLC, 590 B.R. 221, 282-855 (Bankr. D. Del. 2018), the Delaware bankruptcy court considered whether an official committee of unsecured creditors had standing to pursue derivative claims on behalf of a Delaware LLC.  The bankruptcy court ruled that the LLC Act is “clear and unambiguous about who can bring a derivative action: the plaintiff ‘must be a member or an assignee.’” Id. at 284 citing 6 Del. C. § 18-1002.  The court reasoned that because the committee was neither a member nor an assignee, it did not have standing to bring a breach of fiduciary duty claim.  Id.; see also In re PennySaver USA Publishing, LLC, 587 B.R. 445, 467 (Bankr. D. Del 2018) (Delaware bankruptcy court dismissed a chapter 7 trustee’s derivative claims for breach of fiduciary duties owed to creditors of an LLC because the creditors were neither assignees or member so the LLC).

Citadel Watford

More recently, the Delaware bankruptcy court in Citadal examined whether a liquidating trustee had derivative standing to pursue breach of fiduciary claims on behalf of creditors.  See In re Citadel Watford City Disposal Partners, 2019 Bankr. LEXIS 1375.  In Citadel, the debtors included a Delaware LP and North Dakota and Wyoming LLCs.  The official committee of unsecured creditors filed a complaint asserting breach of fiduciary duty claims prior to the confirmation of a chapter 11 plan.  A liquidating trust was formed under the plan for the benefit of the unsecured creditors.  The liquidation trustee succeeded the committee as the plaintiff in the litigation.  A defendant moved to dismiss the litigation arguing that the liquidating trustee did not have standing to assert derivative fiduciary duty claims.

In determining whether the liquidation trustee had standing, the bankruptcy court noted it had to first determine under applicable state law whether creditors could pursue derivative breach of fiduciary duty claims.  Id. at *8

The court interpreted the HH Liquidation and PennySaver decisions to hold “that, under Delaware law, creditors of insolvent limited liability companies do not have standing to sue derivatively on behalf of the company.”  Id. at *12.  Specifically, Judge Carey observed that section 17-1002 of the Delaware LP Act is unambiguous and requires that a “proper derivative action plaintiff “must be a partner of an assignee of the partnership interest.’”  Id.  at * 10.  The court reasoned that the similarity of the relevant statutory language in the LLC Act and the Delaware LP Act, compelled the finding.  Id. at 12.  Consequently, the court held that the Delaware LP Act does not provide authority for derivative standing by creditors who are not partners or assignees and, accordingly, under Delaware law, creditors of limited partnerships lack standing to sue derivatively on behalf of an LP.  Id.

The court next analyzed the Wyoming and North Dakota LLC statutes and concluded that they were “substantially similar to the Delaware statute, had been interpreted consistently with the Delaware court decisions and limit derivative actions authority by status to members at the time an action is commenced.”  Id. at 15.  As a result, the court dismissed the fiduciary claims for lack of standing.  Id. at 16.

Conclusion

The Citadel decision serves as an important reminder that the ability of a creditors committee to pursue a derivative cause of action may depend on the type of entity and the debtor’s state of formation.